Question

With respect to the broad market, briefly explain the informational content of (a) the current 20 year US government bond market (with respect to real interest rates and inflation); (b) the current US dollar (relative to a basket of other currencies); and (c) the price of oil.  In sum, what is “the market” saying about interest rates, inflation rates, real economic growth, and energy supply & demand into the foreseeable future?

Answer 1

At the onset, if we look at the 20-year US government bond, it is evident that the bond yield climbed to a recent high of 3.37% on November 2, 2018. However, bond yields have been gradually trending lower and is currently at 2.83%. The first key conclusion is that inflation expectations have moderated on a relative basis in the last 2-3 months. This is in-sync with the point that global economic growth is likely to be weaker in 2019 as compared to 2018 due to the impact of trade wars.

The dollar index gives further indication of the point I am making. With US policymakers pursuing contractionary monetary policy, the dollar has been strong and the dollar index peaked at 97.5 on November 12, 2018. The dollar index is currently at 95.6 and the relative weakening of the dollar has been due to the fact that the fed has indicated that it is willing to be "patient" on further rate hike. Therefore, inflation expectation remains subdued and this is due to relatively weak economic growth expected in 2019.

Oil prices are also indicating that there is a supply glut. To elaborate, Brent was trading at $86.0 on October 4, 2018 and currently Brent trades at $62.8. This sharp correction in oil prices can be attributed to excess supply over demand visibility. The OPEC has agreed on production cut of 1.2 million barrels of oil per day for the first half of 2019 and this further indicates that demand is relatively weak and likely to remain weak in the foreseeable future.

Therefore, based on treasury yield, dollar index trend and oil price direction, it is clear that inflation is not a threat in the foreseeable future. GDP growth in 2019 is likely to be weak with IMF having revised global GDP growth forecast downwards to 3.5%. Energy supply remains ample and lower energy price is another factor that ensures that inflation remains subdued.

With lower growth projections for 2019, the fed is likely to pause on rate hike and adopt a "wait and watch" stance before there is more clarity on the strength of economic growth.